Readers' comments

Ackman is just trying to fatten his pocket (or enlarge his ego in this case). He has the power to be the elephant in the media and stir the emotions of investors. The company makes $, pyramid scheme or not. Herbalife is dirt cheap even $50. If you disagree with a thriving company's business ethics, get out of investing.

As co-author of the 2002 article with Peter Vander Nat of the FTC that Ackman references on slide #60, I can say with certainty than Prof. Coughlan's paper contains numerous substantial errors. A very poor piece of work. And to think I used to use her textbook.

Would that be the 2002 paper that incorrectly stated that non-binding dicta somehow "redefined" well established precedent and created a whole new category of sale that was neither retail nor wholesale?

Once you arbitrarily redefine a well-defined term - a retail sale is a sale to an end user - the odds are strong you're going to come up with arbitrary conclusions.

As the FTC themselves stated in their 2004 Staff Advisory Opinion, initiated in no small way by the confusion caused by Omnitrition and your paper, what matters is the motivation for purpose, not who is buying it.

If Herbalife distributors are purchasing products for their own personal use because they want the products, then so-called "personal consumption" is perfectly acceptable, indeed logical. If you liked the products, why wouldn't you get them cheaper if you could?

Purchases for personal use as legitimate retail sales is codified in law in a number of US states as well as officially acknowledged in the EU and Canada. Not to mention the purchasers need to pay retail sales taxes!

The potential issue with Herbalife (and a number of other MLMs) is that they have certain rules that can potentially corrupt the motivation for purchase - ie people are purchasing the products in order to obtain some financial reward, and encouraging others to do the same. Ackman outlined one case where this might be true.

The 2004 FTC Staff Advisory adds more confusion than clarification though it makes one clear point, the "critical question" pertains to the revenues that "primarily support the commissions." On this one point our paper, the FTC Advisory, and court decisions agree. In terms of definitions, our paper is consistent with the courts, whether you agree or not.

Your purpose here seems to be to deny the premise that on the one hand some multilevel marketing firms explicitly state their goal is to develop sales among consumer outside of the distribution network (see the recent statement from Herbalife CEO Johnson touting their sales outside of the network). Is multilevel marketing a unique style of direct selling intended to build a customer base among households outside the distribution network or is it, as you suggest, essentially a buying club. I can handle either approach though one lends itself to growth more than the other.

I agree, some distributors purchase for their own consumption. In fact, they are compelled to do so as participants in the network and to retain any possibility of receiving a bonus.

I notice you do not defend Prof. Coughlan's work or any other public report/paper on this subject. Why?

In the end, of course, neither Mr. Ackman nor even the FTC gets to decide if a firm is a pyramid scheme. Only a court can make that decision. Thus far, in Webster v. Omnitrition and BurnLounge, the court and our analysis agree.

If you have no problem with the approach of direct sales, nor of "buyer's clubs", why a problem with operations that lie on a spectrum? Herbalife has reported that a large percentage of it's "distributors" are registered primarily for the purpose of obtaining Herbalife products at the discount price. In 2010 the FTC reported that numerous other direct sales company report the same phenomenon.

Confusion arises because critics of the industry insist these people, who are in essence nothing but retail customers obtaining products at "wholesale" pricing, are in fact part of the distribution network.

Canada has taken a simple route to clarifying this, defining a "participant" in a plan thus -

"A participant in an MLM plan is an individual who actively engages in the activities necessary to realize the benefits of the MLM plan."

I am a registered distributor with an MLM company (not Herbalife), however I am not "engaging in the activities necessary to realize the benefits of the MLM plan". I am merely a retail customer enjoying distributor pricing.

There is nothing legally or ethically wrong with this. Indeed even back in the seminal 1979 FTC vs Amway case, the commissioner made it clear he understood a significant amount of sales volume came from internal consumption.

I have reviewed Professor Coughlan's paper on Herbalife, and assuming her actual data are correct, I see no "susbtantial errors". Would you care to elaborate?

Regarding Webster vs Omnitrition, as numerous expert legal opinions have stated, it is non-binding opinion, it does not set a precedent.

The Burnlounge decision confirms, correctly in my view, that internal consumption cannot be used as evidence of legitimate market demand. This can be determined through other methods, including, yes, "outside" retail sales. Other methods include market price comparisons.

On the latter I'd note Ackman often gets it completely wrong. Two examples - he cites a competitor multivitamin product as retailing for $0.11/tablet when the actual retail price is $0.20/tablet. This is similar to the Herbalife distributor pricing, and the Herbalife product appears to have superior ingredients. In the same comparison he selects a range of cheaper products where even an elementary review of the ingredients shows they are not even remotely comparable products to that offered by Herbalife. One wonders if he bothered investing any of his extensive funds in consulting with expert nutritionists.

In another example he cites a competitor protein shake as costing $1.74/200 calorie serving when in fact it retails at $2.28/200 calorie serving. In yet other cases he takes for example a Sam Club's "members" pricing and compares it to Herbalife's full-price pricing, when Sam Club's yearly membership fee is more than double that of Herbalife. Simply an unfair comparison.

"In fact, they are compelled to do so as participants in the network and to retain any possibility of receiving a bonus."

This is false not only for Herbalife, but virtually all other MLMs. Some MLMs have required monthly volumes to qualify for bonuses, but in all cases I am aware of qualification can *always* be achieved through customer sales volume, no personal use required. Indeed, some MLMs *require* not personal purchases, but customer purchases.

Myths surrounding this industry are rife, and it's a shame when otherwise well credentialed people contribute to the problem.

I have no problem with a buying (or buyer's) club per se. I do have a problem with a firm saying it is one thing and operating as another. It is not possible for any multilevel marketing firm to have 90% sales outside the distribution network (per CEO Johnson re: Herbalife) and be the internal consumption company you describe. Which are they? What are the primary revenue drivers? You mention a firm could be this or could be that. Well, the public and investors deserve to know the underlying business model. The firms have the data to show EXACTLY how they make their money.

Confusion comes when companies present themselves as one thing then defend themselves as something else. Let the multilevel marketing firms who want to be buying clubs say they are buying clubs (and my guess would be that they could pretty much close that link labelled "Business Opportunity")

Funny you mention the 1979 case that actually set the 10-customer rule based on Amway's assurances that it had retail customers outside of the distribution network (and perhaps it did). Or was Amway a buying club in 1979?

Since you do not find Webster v. Omnitrition binding it is not surprising you see no errors in Coughlan's work. BurnLounge is consistent with Omitrition on the retail question and not consistent with your earlier argument. Will that be not binding as well? What about Koscot?

I will let Ackman defend his own story (and his own motivations). My position (in writing) has been public since 2002. I have successfully assisted in the prosecutions of pyramid schemes posing as legitimate multilevel marketing as has my co-author. I have never said all multilevel marketing firms are anything, one way or the other. I have expressed concerns, however, about some firms because of the confusing stories told by the firms themselves, as you have done here. Is it a buying club? Why all the confusion about sales outside the distribution network? Is sales outside the network a goal an key revenue source (has implications for investors)? Is it measured? How are distributors held accountable to company policies? What is the role of "business services" and the impact on profits for upline distributors (perhaps you are one of those)? Does compensation rely primarily on recruit? If, not, show the data.

While technically, according to stated policy, distributors may not be required to make purchases for their own consumption, in reality they face pressure to do so. Plus, as the business opportunity is a primary part of the business model, the fact that bonuses are contingent on personal volume makes personal purchases important.

I would be happy to help dispel the myths, help separate a legal business model from ones found by court cases to be pyramid schemes. I know the data I need and I welcome a constructive conversation. There have been enough companies found to be operating pyramid schemes who claimed to be legitimate multilevel marketing that we cannot presume that no current multilevel marketing firm is a pyramid scheme. Let's clear all that up with more transparency. Ready?

I entirely agree with Bill Keep's comments concerning the poor quality of Prof. Coughlan's Herbalife scholarship. I have posted an article on Seeking Alpha which details the flaws and misleading statements in Prof. Coughlan's Herbalife papers. http://seekingalpha.com/article/1103871-analysis-of-anne-t-coughlan-s-he...
Bill, I am glad to see you are still fighting the good fight!

I highly recommend Mr. Brook's article - an excellent and careful analysis of Ms. Coughlin's writings. I also want to affirm Mr. Keep's comments that this does not have to be a mystery. Proper disclosure and record-keeping could help distinguish true internal consumption from purchases aimed at bonus attainment, and identify sales to out-of-network retail consumers. If Mr. Steadman's assertions are correct, the data will confirm them. It is simply ludicrous for firms to suggest that there is "no way to know".

(1) You may want to consider consulting with several lawyers about whether Webster vs Omnitrition is binding or not.

(2) The idea that companies are somehow "hiding" that they are (partly) buying clubs is absurd. It was acknowledged in FTC vs Amway 1979. The FTC themselves discussed it in their most recent discussion paper on their new business opportunity rule. MLM reps actively promote the ability to be a passive distributor and purchase at distribute pricing.

Why do you believe a company cannot be simultaneously a buying club and a business promoting the sale of products both through the "club" and to outside customers?

Forget the law - what issue do you have with it?

As for not presuming "no current multilevel marketing firm" are pyramid schemes, I entirely agree. I expressed as much about Burnlounge some years ago, and there are more.

Ackman has raised some legitimate questions about Herbalife's operations in his presentation. Being a pyramid scheme is not one of them

The issue with your second point is pretty simple. As an investor, would it matter to you which business you are investing in? One model has far more growth than the other and thus makes a great deal of difference to those forecasting business growth opportunities when evaluating it as an investment.

I do company diligence for a living, and I've looked into a few different MLM companies where family members have asked my opinion before buying into the structure.
To me the distinction between a legitimate going-concern MLM business and a pyramid scheme is whether the business generates a sustainable base of profits after you exclude any profits generated WITHIN the multi-level sales force ("distributor") structure. Unfortunately, that's a very difficult question for anyone to answer from the outside with most MLMs because they don't disclose. Furthermore, many are private entities, typically based in Florida or the Caribbean, and often run by lawyers. There's nothing wrong with being private, based in Florida, or run by a lawyer. However, taken as a whole, and layering on top of this an MLM business model and a lack of solid financial information, there are just too many red flags. Why would you risk your money in a venture like that?
Herbalife will be an interesting case because they are a public MLM (although note that they are HQ in Grand Cayman). I looked up their reported financials briefly just now, and a couple things stood out worth investigating:
1. They had a significant change in how they accounted for gross margin in 2008. They now report "royalty overrides" above the gross margin line. If I were shorting the stock, I'd be very interested in understanding the definition and measurement of royalty overrides and how they are treated in the financial statements. In 2011, for example, this was a $1.1B charge for a company that generated operating income of $562M.
2. In 2011 the company reported "shipping and handling revenues" of $510M (above the Net Sales line). Again comparing to $562M of operating income, and it sure looks like a critical profit center for the company is shipping and handling. It makes me question whether there is a real profit being generated from the underlying products sold to end consumers. Because of there isn't, then as the hedge funds hypothesize, the model isn't sustainable over time.
The hedgies may be on to something here. Will be fascinating to see it play out in a public company.
And full disclosure: I have no position and no intention of taking a position in Herbalife.

As an Herbalife distributor for nearly 12 years, I feel qualified to answer some of your comments.

While I am, by training, an RN, not an economist, I have a strong understanding of the business model, and the marketing plan by which the distributors are compensated.

Retail sales is the backbone of the company. It's crucial, within a network marketing company, to ensure that, whether or not one desires to grow an organization and collect wholesale and royalty profits, one can make money from the sale of legitimate products.

To that end, the products must do what you tell your prospective customer they do, and they must be priced so that they will be within the budget of the bulk of your potential customers, as well.

Herbalife has a vast system of quality control that exceeds, in every country where we do business, the requirements for our products. In the US, we far exceed the requirements for prescription drugs, as well.

Our products are more than competitive with those one might buy from a store such as GNC, with considerably more care and QC put into their manufacture.

The end result is that I am absolutely comfortable offering Herbalife products at retail. And I am also happy, if a customer becomes a repeat customer, to offer the opportunity to become a discount customer.

Because we have no buying requirement, it's an easy decision for many people. As such, the comment that the bulk of distributors make no money is true. They are distributors in name only, and purchase products, when and if they need them, for their own consumption.

I can't comment on bookkeeping methods, but I can tell you that royalty overrides are the payouts to distributors who have achieved a higher level in the marketing plan, based on purchases by those in their organizations who are at the same discount level.

As was noted in a previous post by DanDistributor, some of those people may be at a higher level, due to their greater efforts.

Many years ago, when I changed job, back in Europe, I participated in one of these marketing organizations meetings. I was not in need to find a job, therefore I could think about it. I decided that in order to make money you would have to approach hundred of people to recruit and sell them something they do not need.
Legally, I do not know whetehr this is a pryramid scheme, kind of Ponzi scheme, but is very similar.
I calculated that if I approached all my friends with the sales arguments of the company, I would very soon had no friends anymore. They would be fed up with me. And I think this is what ahppens to most of them

"In a pyramid, recruitment is everything. People pay to participate, and are rewarded by finding others willing to pay to join. At some point the supply of new recruits dries up and the pyramid collapses."

The U.S. Federal Trade Commission stated in 2012 that a subset of the multilevel marketing industry does likely meet pyramid scheme criteria, but that the determination needs to be made on a firm-by-firm basis with detailed fact finding. To state broadly that multilevel firms are legal is to miss the complexities of this industry. The scrutiny Herbalife is experiencing is exactly this kind of detailed evaluation of compensation and retail practices. As an economist who researches this industry, it is frustrating to see research funded by the industry provided as counter-evidence. If this industry, and its individual firms are to be truly understood, objectivity is paramount.
Stacie Bosley, Hamline University

Professor Bosley makes excellent points. The Herbalife-funded papers by Professor Coughlan are remarkably superficial and contain numerous deceptive and misleading statements concerning the MLM industry and Herbalife in particular. I am an attorney who has prosecuted class actions against a number of MLM companies, including Herbalife, and have advocated for better disclosure and regulation of the MLM industry. Herbalife, like most MLM's, fails to disclose key information concerning its distributors, including attrition rates, retail sales (Herbalife requires its distributors to maintain retail sales records, but it studiously avoids collecting this information), and the actual earnings and expenses incurred by distributors. Coughlan's papers are not worthy of being quoted or relied upon by The Economist.

Direct Marketing (MLM) Companies place most of the focus on recruiting as many agents as possible and this leads to saturation – too many agents and too few customers.

In most cases, the products are over-priced compared to retailers, so customers can easily buy similar products for less elsewhere.

Agents spend a lot of time trying to sell the products and also in recruiting other agents. If the total time spent by an agent is taken into account, the pay will be very low. Most people do not calculate the opportunity cost of doing direct sales and are even unaware of the concept of opportunity cost!

Many of the claims about earnings are not verified and are either false or inflated.

For example in 2008, a UK high court judge Mr. Justice Norris said in a case against Amway brought by the then Trade Secretary Lord Mandelson, that independent operators had misrepresented their own income and were "selling a dream" with people who bought into that dream being deceived about how much they could earn.

These companies give the impression that people only need to work a few hours a day to make serious money. This is simply a gimmick!

The drop out rate of agents is very high. This is because people only realize that they cannot make money after doing the work for a while.

In developed countries with highly developed retail industries and the massive growth of e-commerce, the need for agents to visit customers to sell items that can be bought for less will diminish in the years ahead.

Hype. As opposed to the common factor in automobile marketing, restaurant sales or the movies.

All network marketing companies are not created equal. Herbalife does NOT require a purchase of product to become a distributor, but, of course, the new distributor is encouraged to order enough for him or herself. Would you trust a doctor who told you to use a certain medication, and hadn't researched it?

The easiest way to research good nutrition's action on the body is to eat it, and distributors are, of course, encouraged to do so.

There is no monthly purchase requirement, unless one is at a higher level, and begins to qualify for royalties. In order to collect them, one must fulfill two requirements: to purchase a specified volume of products in the month (from about $550 to $2750 USD to collect the full royalty) and to file a document stating that one had sold at retail, to a minimum of 10 customers, at least product worth about $1100 USD.

After all, if one is to make money from the efforts of others, one also should be required to make an effort.

You have a factual inaccuracy in your article: "These sellers are recruited by people on a higher tier of the marketing structure, who receive a slice of the commission on sales made by those whom they recruit." New members may indeed be recruited by someone on a higher tier if the marketing structure, but they may also be recruited by someone on the exactly the same entry level tier of the structure. The new person is then able to advance to a higher level of the structure than the person who recruited them, based on their own productivity, and this is a common occurrence within Herbalife.

Advancement within Herbalife is not based on seniority, order of signing or waiting for someone higher up to move on to other things - it is a pure meritocracy.

Also, to clarify, new distributors "who are required to buy a batch to join the sales force" will receive enough product for their personal use only in the 1st required purchase. This should not be interpreted as some kind of 'mandatory buy-in' product batch of £1,000 or so, it is a personal use nutrition programme and the whole starter pack is less than £100 which covers the cost of registration, some training materials and enough products for the new Distributor to personally experience the nutritional benefits of the products.

Yes, a larger quantity of product needs to be purchased from the company in order to move up the discount scale, but this can be spread over a 12 month period on an accumulative basis, enabling new Distributors to grow their customer base and increase their profits on a financially comfortable step by step basis. This is now the most popular way for new Distributors to climb the initial steps of the structure, with many Distributors achieving this without any significant recruiting activity. This is of course in direct contradiction to Ackman's theory, but I expect he will have made his money and cleared off by the time the truth hits home.

One thing I agree with is MLM is a great training ground. It has opportunities for those who persevere and earn over time. Much as you call it a pyramid it is not easy climbing the up to apex of earning royalties. It must be good if those goods are changing hands and employing so many people around. Billions of dollars per annum means some people are keeping their eyes on MLM with serious development.

If the required bulk purchase to join is considered as a membership fee then it is a pyramid scam.
Most members never sell the stuff so the profit doesn't really come from product sales it comes from people joining. They are just renaming the 'sign-up fee' and calling it a 'required purchase'

Another scam everyone should be aware of is the Amway Tool Scam. Google "Stop The Amway Tool Scam Wordpress" for more information, and forward this to every non-Distributor/IBO you know, so they don't get scammed.

I've looked at several MLM schemes over the last few months and every single one of them had the same characteristics: some form of buy-in with stipulated monthly minimum reorders, stories about how much you can earn coupled to a reality that is very different: a handful of people at the very top making huge sums while most participants (more than 97% of the total) fail to break even. While such MLM scams may skirt the law and thereby be "legal" they are most definitely "not kosher." I stopped researching MLM after the 17th company and needed some "mind soap" in order to clear away a feeling of deep disgust.

MLM. It's not a job it's an opportunity!
Anyone who worked or knew someone who's worked in direct sales will have heard that line.
Having said that I once heard that Amway had some of the best sales training around.